Market Conditions and Investment Strategy

Markets are funny beasts. Efficient? Perhaps. Manic? Always. What has been going on since everyone came back from the beach is quite simple: risk off. There has been a quiet but vicious downdraft in both credit and small cap equities which has really been hidden by those following the Dow and the S&P 500. As high yield bond spreads have widened dramatically over the last month to levels not seen in over a year, we believe this provides an attractive entry point into high yield corporate debt. To see our full commentary on current market conditions and how we are investing accordingly, click here.

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High Yield Market Technicals

It has been a long quiet period in credit but volatility has returned with a vengeance. I have had an opportunity to discuss this with a number of our institutional clients in recent days, but there are a few factors that are exacerbating the recent price declines in the high yield bond market. To cut to the chase, most importantly for investors, we see this as representing a fantastic opportunity to buy this market aggressively on the cheap and capture a liquidity premium created by the law of unintended consequences. With over thirty years of experience in this market, I do not see it as a value trap or a fool’s errand. Nobody is making the case that a huge default cycle is about to begin in either the high yield or loan market, so from our perspective the fundamental fears are fairly non-existent. It does not mean that we won’t see defaults. We certainly will, as evidenced by the biggest failure of all Texas Utilities (aka Energy Future Holdings). But these remain a very, very small percentage of the overall high yield market which is now approaching $1.7 trillion. We have the Fed (Yellen and Fisher) barking at the moon, talking about risk in the high yield market. My best guess here is that they are trying to warn the market of impending rate increases. They surely cannot be talking about fundamentals of corporate high yield debt issuers, which they would have no idea about. My advice is for them is to talk with the investment grade corporate and mortgage community which have much more significant exposure to higher rates. Our asset class is among the lowest duration among the major fixed income sub-groups.1 We have written chapter and verse on why we see rates going nowhere so let’s leave that alone for now.

Let’s turn our attention back to the law of unintended consequences. Post the 2008 carnage, governments across the globe have been working overtime to “reduce” systemic risk in the financial system. What they have done is created a series of regulatory mechanisms (Basel III, Dodd-Frank and Volcker) that has penalized any type of risk taking. This includes market making activities for all the major banks/broker dealers. So what we have is very thin secondary markets. What has happened recently is that significant selling has been met with low-ball bids or none at all. The bonds in many cases have to experience “price discovery,” whereby investors such as Peritus and others become the market. Said another way, there are brokers but no dealers.

This is not really a surprise to anyone, but this is one of the first stress tests in bondland since the new regulations have taken hold. While there is short term pain involved, we see the potential ability to capture sizable liquidity premiums and buy discounted bonds as incredibly attractive and very timely. Attractive because we don’t believe that anything fundamentally has changed. With the recent and substantial widening of spreads, we believe it is simply a matter of time before institutional investors re-allocate monies to our asset class and the liquidity premium and overall spreads tightens back to much lower levels.

1 See our blog “High Yield Bonds and Interest Rates” for actual comparisons of durations of investment grade, municipal, and high yield markets.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income or equity securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
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Oil Market Dynamics

Oil is down the most in 22 months today. Brent Crude fell more on the day than West Texas Intermediate (WTI) and it primarily comes back to the unexpected supply increases out of Libya (being at the highest level in over a year), as well as weak economic data from China and Europe potentially curtailing demand. The market is currently viewed as being well supplied with no clear bomb set to explode in the visible future. US production continues to grow and Iraq hasn’t had any problems with production lately, despite the ISIS presence there. The other usual suspects, such as Nigeria, have also been relatively subdued. As a consequence we are seeing oil slump. However, Brent futures for November are about $3.00 higher than today’s levels, which is still lower relative to prices we have seen so far this year, but not at nearly 2-year lows like we’re at today; the point being that the market doesn’t really believe that prices will last at these levels. Production is back from Libya today but could easily be gone tomorrow. We see a lot of upside price risk in the market.

OPEC dictates oil prices and honestly we don’t know what the reaction to these low levels will be from OPEC. They might cut production. The Iranian minister was on TV the other day saying it’s time for OPEC to cut, but the Saudi’s are the ones who for all intents and purposes make the decision, and they are seemingly none too happy with how they have been treated by Obama. As such this may be an opportunity to squeeze the US energy sector a little. They also may be tired of being the swing producer. Nobody knows for sure, but history shows us that they will likely step in with efforts to boost pricing.

Our research has shown that production from unconventional sources such as shale, deepwater exploration and oil sands mining require $90-100 oil to make a modest return. These unconventional barrels have become a critical source of supply for the world. As such we can’t expect prices to drop below these levels for very long or the projects simply aren’t economical, in turn likely impacting supply and ultimately driving prices back up.

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A Look at Concerns Impacting the High Yield Market

Be it interest rate concerns or talk of a bond bubble, the high yield market has faced a step back over the past couple weeks. We’ve addressed the interest rate concerns at length—see our piece “Strategies for Investing in a Rising Rate Environment” and blog “Is This Time Different?”—and at the end of the day, history would indicate that high yield bonds have historically performed well during a rising rate environment.

Turing to the bond “bubble” talk, let’s look at the 2005-2007 period when we really did see concerning conditions in the high yield bond market. Looking at the Credit Suisse High Yield Index as a proxy for the market, we saw spreads break 400bps in July 2005 and stay under this level until bottoming out at 271 bps in May 2007.1 This is a far cry off of the spread of 475bps that we sit at today.2 And while concerns have recently been raised about loosening underwriting standards and a pick-up in “covenant lite” activity in the loan world, we certainly aren’t seeing the lack of discipline across the board as we saw in 2005-2007, where deals were getting down at massive multiples (many of which have since proved unstainable) and we saw telling signs like an abundance of PIK (pay-in kind versus cash interest pay) and dividend deals. Over recent years, market issuance has been dominated by refinancing rather than this sort of activity and transaction multiples for M&A have been relatively tame. So, this isn’t 2007 and we don’t see conditions that warrant labeling the high yield market a “bubble” that should be avoided. If anything, the volatility that we have seen over the past few months speaks to rationality—markets can’t continually go up and we would see a periodic step back as healthy.

We’ve heard lots of other reasons why we are seeing sellers in the market, and there seems to be some inconsistencies in some of these reasons. I’ve heard the concern that if rates do rise, that could lead to a set-up in defaults. A couple things to keep in mind: generally we see rates rising during periods of stronger economic activity. We would think that for a substantial rise in rates to happen, we would need to see the economy improve off of where we are today. That doesn’t mean that we won’t still potentially see the Fed take short term rates up little next year at some point, but we would expect that for this Fed to make a big move, they would certainly need to see improved economic conditions, especially in areas such as unemployment and underemployment. And on the flip side, if those strong economic conditions are there by mid-2015 and beyond, then that is a benefit to corporate credit as we would presumably see improved financial prospects for these companies…and one would then think improving financial prospects would in turn equate to lower defaults.

Maybe this is an obvious statement, but the other thing to note as we think about defaults is that higher rates don’t necessarily mean that costs get more expensive for high yield bonds issuers—high yield bonds are fixed rate securities and the fact that so much of the market has refinanced bonds over the past few years and locked in low rates (saving on interest costs) positions them well to manage through the environment ahead. And with the fixed coupon on these securities, that helps keep free cash flow cash generation steady.

On the flip side, potentially higher interest rates mean that companies needing to refinance would face likely higher rates to do so—but again, we don’t see a massive spike in rates on the horizon so that could well mitigate this issue. Additionally, it is important to keep in mind the amount of bond maturities over the coming years. As you can see from the chart below, of the $1.6 trillion market, we only have a very small portion maturing between now and 2018/2019 when maturities start to pick up, so this bodes well for any sort of refinancing risk in the near-term as we seemingly have years of runway.3

Blog 9-29-14

Turning to another issue we have seen mentioned several times over the past week or two: concerns are being raised that companies are focusing on more shareholder friendly activities, such as using cash for stock buybacks. While yes, that can be an issue, there are other caveats to consider. For instance, while we never like to see cash go out the door for stock buybacks or dividends, we often see this occurring in companies that are generating good cash flow that they want to do something with—and free cash flow generation is virtually always a positive. As a bond holder, it is also important to keep in mind that these sorts of equity-focused actions can easily be turned off should that cash flow be threatened. Additionally, active managers can avoid the credits where the company is levering up to unsustainable levels or using cash they don’t have to spend to fund these shareholder friendly activities.

Finally, some also attribute the recent selling pressure in the high yield market to global weakness and a general risk-off trade. Also mentioned are certain industries under severe pressure. This seems more of a rationale argument, as we can’t deny that we are certainly seeing economic weakness in certain areas of Asia and Europe, not to mention the issues in the Middle East, Russia, and Western Africa. But we argue this is why we view active management as so essential. Active managers can avoid names that would have large exposures to these areas facing weak economic activity or other geopolitical issues, and focused more on North American-focused companies, which makes up the predominant portion of the high yield space. And active management is equally important in assessing industries under pressure. Our experience has been that industries facing challenges can actually create opportunities for active managers that can parse out the strong players that they view as undervalued and likely destined to benefit from a change in the competitive landscape, from the weak players that are likely destined for failure.

At the end of the day, we don’t see a sizable interest rate hike on the horizon unless we were to see a strong recovery in the economy, and if that is the case then we believe high yield corporate credit stands to benefit from the improved economy and has historically managed rising rates well (again see our piece “Strategies for Investing in a Rising Rate Environment” for historical data points and further detail). Certainly we don’t see a rising rate scenario as an automatic trigger for defaults to quickly spike—defaults generally increase during times of systemic issues, which we don’t see on the horizon, not to mention the forward maturity schedule is very manageable. We feel that the recent selling pressure creates an even better entry point in terms of purchasing credits and can help to increase potential yield and capital gain generation for investors.

1 The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
2 The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. Level as of 9/25/14.
3 High yield market size of $1,588 billion, Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  June 27, 2014, p. 5.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income or equity securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
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Duration-Based Investing: Yield Matters

It would be hard to have missed the call in the fixed income space for “short duration” products over the last year.  Duration is a measure of interest rate sensitivity (the percentage change in the price of a bond for a 100 basis point move in rates), so the lower the duration the theoretically less sensitive those bonds are to interest rate movements.  Lower duration bonds would not eliminate the interest rate impact, just lessen it.  We see this as a good strategy broadly speaking if you are talking the high yield asset class versus the investment grade asset class, with the high yield market naturally having a much lower duration.  However, we believe this strategy is lacking when it is used to parse out the high yield space itself, investing in only the lower duration names within the high yield category.

This gets back to the concept of yield.  In a box, this sounds like a good strategy, but you need to factor in the starting yield on the portfolio to mathematically assess if practically speaking this is the right strategy.  If you were to invest according to a “short duration” strategy in the high yield market, let’s hypothetically say you could achieve a portfolio with a duration of 2.0 years, so a 100 bps change in rates over 6mos would mean that the price of your portfolio would theoretically decline by 2.0%.  If your starting current yield on the portfolio was 6.5%, meaning you theoretically generate 3.25% of income over that 6mos, then you are looking at a theoretical net gain of 1.25% (3.25% – 2.0%) over the period of rising rates.  However, if you can build a portfolio in the high yield bond and loan market investing according to both maximizing yield and considering duration, let’s say you can build a portfolio with a duration of 2.5 years and a current yield of around 9%.  In this case, your theoretical sensitivity to a 100bps movement over 6mos would be a price change of 2.5%, but you would be theoretically generating 4.5% of income over the 6mos, so your net theoretical gain would be 2.0%.  If that 100bps interest rate movement is over a year instead of 6 months, that yield benefit gets even larger, putting you at a theoretical net gain of 4.5% for the hypothetical short duration portfolio versus a theoretical gain of 6.5% for the higher yielding portfolio.1  And of courses, if rates don’t move or even decline from current levels, then the higher yielding portfolio would not only benefit from the higher starting yield but a theoretical positive price movement per the duration calculation.

We believe this demonstrates that investing purely according to a short duration strategy and not factoring in yield is not necessarily the wisest way to approach this environment.  At the end of the day, yield matters.  A higher yield can go a long way in making up for relatively small differences in duration.  Furthermore, even if rates do rise, it very well can take longer than many expect, making the argument for the higher yielding portfolio versus the purely short duration portfolio even stronger.

For more on the high yield market’s historical performance during periods of rising rates and the current strategies in place, and their deficiencies, to address a potential rising rate environment, see our updated piece, “Strategies for Investing in a Rising Rate Environment.”

The duration and price movement relationships are approximates and calculations are provided for illustration only.  These calculations assume that credit spreads remain constant and do not factor in any fees or expenses or changes in price movements for other reasons, including security fundamentals, etc.  Actual results may be materially different.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income or equity securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.

 

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Peritus in the News

Peritus was featured in the article “Why I Own HYLD” by Heather Bell in ETF.com’s “ETF Report,” September 2014, p. 26.

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Peritus in the News

Tim Gramatovich, Chief Investment Officer of Peritus, was quoted in the article “Digging into Debt” by Asjylyn Loder, in Bloomberg Markets, October 2014.

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Energy Market Update

Access to and pricing of energy in all forms matter immensely to consumers, markets and economies. Prices of electricity, gasoline, diesel and jet fuel are directly affected by oil prices and impact all consumers. We have seen the pricing on near month WTI oil futures contracts fall over the last month and during the past year. So does this have any real impact on our portfolios and does it change our thesis of higher oil prices in the future?  Click here to see our update on the energy market.

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Is This Time Different? A Look at Duration

As we have written about, historically speaking the high yield bond market has performed well during periods of rising rates (see our piece, “Strategies for Investing in a Rising Rate Environment”), due to the fact that the high yield market tends to have a lower duration than other fixed income asset classes, has a zero to negative correlation to Treasuries, and generally rates are rising during periods of improved economic environments, which is a positive for these credits.  However we were recently asked if this time is it is different because of the historically low rates.  We believe that the answer is both no and yes.

Generally speaking, we believe that the factors that have helped insulate the high yield market from higher rates in the past still are valid today—the relatively low duration and the fact rates generally increase during an improving economy.  Addressing the latter first, we would expect that if the Fed does eventually raise rates, it would need to be on the back of an improving economy.  We would expect that in order for a sizable increase in rates we would need to see an improvement in the economy off of where we are today, and we would expect those economic conditions would benefit corporate credit.

Turing to the relatively low duration, looking at duration levels over the past nearly 15 years, we see that current duration levels are certainly not elevated by historical standards.1

Blog 9-15-14

Duration is a measure of interest rate sensitivity, and takes into account yield.  Though there are different ways of calculating duration, it is broadly defined as the effect a 100 bps (1.0%) change in interest rates would have on the price of a bond.  One would think that if the currently low yields by historical standards were to dramatically change our interest rate sensitivity going forward, that would be reflected in the duration number.  But as the graph above indicates, we are not seeing an elevation of duration.

However, on the flip side, we are seeing a portion of the market that is at very tight yields, so the usual benefit that a higher starting yield the can help cushion the rate change does not hold water for this segment of the market.  The following chart depicts the issue.2

Blog 9-15-14b

The highest rated piece of the high yield market, split BBB has a duration over 1 year longer than the next two highest ratings categories (BB/Split BB).  Then once you get down to B rated securities and below, you are looking at about another year decline in duration.  We see this split BB to split BBB portion of the index as trading more along the lines of investment grade, which does have a positive correlation to Treasuries and has historically performed well under that of the high yield market during periods of rising rates (though still a positive performance, see our blog “High Yield in a Rising Rate Environment: A Perspective on Historical Performance”).  When we talk about tight yields, this highest rate portion of the high yield index exemplifies the issue, trading at a yield to worst of 3.81% for split BBB and 4.3% for BB rated bonds, bringing down the broader index statistics.

This is why active management within the high yield market is essential.  Active managers are able to avoid the quasi-investment grade names that trade at very low yields and higher durations, the credits that we would expect to be much more impacted by interest rate increases, and take advantage of credits that are at seemingly attractive levels.

1 Modified duration for the Credit Suisse High Yield Index for the period of 1/31/2000 to 8/31/2014. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
2 Modified duration for the Credit Suisse High Yield Index based on the designated ratings categories as of 8/31/2014. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income or equity securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
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Size Constraints and Price Action in the High Yield Market

Over the past several years we have seen a shift in high yield bond trading as exchange traded funds (ETFs) have grown to be a prominent force within the high yield market.  While ETFs still represent a relatively small portion of the total $1.6 trillion market1, the index-based ETFs seem to have a disproportionate impact on the daily price movement we are seeing in the high yield space.  This is especially true during the periods of large inflows or outflows within the high yield market.

It is important to keep in mind that the two biggest high yield ETFs have size constraints, whereby they are left to essentially invest in only a portion of the high yield market, while largely excluding issues that do not fit their size criteria.  By their investment mandates per their respective underlying indexes, the SPDR Barclays High Yield Bond ETF (ticker JNK) has limited ability to invest in bond tranches below $500 million and iShares iBoxx $ High Yield Corporate Bond ETF (ticker HYG) has limited ability to invest in bond tranches below $400 million and from issuers with less than $1 billion of outstanding face value.2

So with this, we have seen a shift in focus toward the larger, “flow” names that fit the index size criteria.  These large issue-size credits now tend to be more volatile, as the fast money moving in and out of the high yield space now seems to often be concentrated in these index-based ETFs.  On days of heavy inflows, we often see upward swings in these underlying bonds and, alternatively, on days of outflows, we have seen notable downward pressure on these names.

Price action based on index inclusion has become a real factor in the high yield market, and we see it as an inefficiency within the market that can benefit active, unconstrained fixed income investors.  For instance, as of YE 2013, high yield ETFs accounted for 11.9% of total retail high yield fund assets (mutual and exchange traded funds)3, but on weeks like the past week, we saw ETFs account for 58% of the weekly fund outflows4, which puts pressure on those large, “flow” bonds and can create buying opportunities for those not subject to fund outflows.

But above and beyond that, the biggest benefit we see from this size criteria inefficiency within the high yield market is the ability to purchase credits that do not meet this size criteria and are excluded based on their issue size.  It is often in these smaller issue-sized credits that don’t meet the $500mm issue or $400mm issue/$1bil debt outstanding size requirements for inclusion in the passive funds, or credits overlooked by other large active vehicles that have massive mandates to fill and Wall Street sell-side research, that we find the best opportunity for value.  We believe the ability to look where others can’t or don’t is a recipe for potential alpha generation.  And in today’s market where so much focus is put on the tight yields, we see it as a way to find better yielding opportunities in underlying credits that we view as attractive.

1  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  April, 4, 2014, p. 43.
2  Fund restrictions sourced from the ETF prospectus and summary prospectus at https://www.spdrs.com/product/fund.seam?ticker=JNK and http://us.ishares.com/product_info/fund/overview/HYG.htm. Size limitation based on the underlying indexes for each fund. The fund may use a representative sample of the underlying index, which means it is not required to purchase all securities in the underlying index. Both funds may invest up to 20% of the portfolio in assets not in the underlying index.
3  Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “2013 High Yield-Annual Review,” J.P. Morgan North American High Yield Research, December 23, 2013, p. 123.
4  Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li.  “Credit Strategy Weekly Update.”  J.P. Morgan, North American High Yield and Leveraged Loan Research.  September 12, 2014, p. 6.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and other fixed income or equity securities involves various risks and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.
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